Aman Ltd. is a leading manufacturer of automotive components.

It supplies to the original

equipment manufacturers as well as the replacement market. Its projects typically have a
short life as it introduces new models periodically.

You have recently joined Aman Ltd. as a financial analyst reporting to the CFO of the
company. He has provided you the following information about three projects, A, B and C
that are being considered by the Executive Committee:

 Project A is an extension of an existing line. Its cash flow will decrease over time.

 Project B involves a new product. Building its market will take some time and hence
its cash flow will increase over time.

 Project C is concerned with sponsoring a pavilion at a Trade Fair. It will entail a cost
initially which will be followed by a huge benefit for one year. However, in the year
following that a substantial cost will be incurred to raze the pavilion.

The expected net cash flows of the three projects are as follows:

Year Project A Project B Project C

0 (15,000) (15,000) (15,000)
1 11,000 3,500 42,000
2 7,000 8,000 (4,000)
3 4,800 13,000 --

The CFO believes that all the three projects have risk characteristics similar to the average
risk of the firm and hence the firm's cost of capital, viz. 12 % will apply to them.
You are asked to evaluate the projects.

1. What is the payback period and discounted payback period? Find the payback
periods and the discounted payback periods of Project A and B.

2. What is the net present value (NPV)? What are the properties of NPV? Calculate the
NPVs of projects A, B and C.

3. What is the internal rate of return (IRR)? What are the problems with IRR? Calculate
IRRs for projects A, B and C.

4. What is the modified internal rate of return (MIRR)? What are the pros and cons of
MIRR vis-à-vis IRR and NPV? Calculate the MIRRs for projects A, B and C assuming
that the intermediate cash flows can be reinvested at 12 % rate of return.

QUESTION 1
Payback period is the length of time or the number of years required to recover the cost of
an investment in a project. It is an important determinant for investors whether to undertake
the project or not, since longer payback periods are considered undesirable for investment
positions. The payback period ignores the time value of money.

Discounted payback period is one of the capital budgeting techniques that are used to
determine the profitability of a project. A discounted payback period gives the number of
years it takes to break even the initial expenditure. Unlike payback period, discounted
payback period takes into account the time value of money and discounted the future cash
flows.

Project A
Year CF ƩCF PV of CF ƩPV of CF
0 (15,000) (15,000)
1 11,000 11,000 9,821.43 9,821.43
2 7,000 18,000 5,580.36 15,401.79
3 4,800 3,416.55

PV1 = 11,000 PV2 = 7,000 PV3 = 4,800

(1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3
= 9,821.43 = 5,580.36 = 3,416.55

15,000 – 11,000
Payback Period = 1+
7,000
= 1.57 years

15,000 – 9,821.43
Discounted Payback Period = 1+
5,580.36
= 1.93 years

Project B
 Year CF ƩCF PV of CF ƩPV of CF
0 (15,000) (15,000)
1 3,500 3,500 3,125 3,125
2 8,000 11,500 6,377.55 9,502.55
3 13,000 24,500 9,253.14 18,755.69

PV1 = 3,500 PV2 = 8,000 PV3 = 13,000

1 2
(1 + 0.12) (1 + 0.12) (1 + 0.12)3
= 3,125 = 6,377.55 = 9,253.14

15,000 – 11,500
Payback Period = 2+
13,000
= 2.27 years

15,000 – 9,502.55
Discounted Payback Period = 2+
9,253.14
= 2.59 years
QUESTION 2

Net Present Value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows. In capital budgeting, the NPV is used to analyse the
profitability of an investment or a project. Generally, an investment with a positive NPV will
be a profitable one while the other way around where the NPV is negative, the investment
will give a net loss. Therefore, it is advised that an investment to be made with the one that
has a positive NPV value.

There are three basic properties of NPV.

i. When the income amounts are high, the NPV is usually high. This is because when the
income is high, the discounted value of cash flows will increase and the amount of cash
flows also increases.

ii. When the incomes of a project come sooner, the NPV will be high. On the other hand, it
will be low, when the incomes take a long time to be realized.

iii. The NPV is different at different discounting rates. Increasing the discounting rate will
reduce the amount of NPV.

NPVA = 11,000 7,000 4,800

1
+ 2
+ – 15,000
(1 + 0.12) (1 + 0.12) (1 + 0.12)3
= 9,821.43 + 5,580.36 + 3,416.55 – 15,000
= 3,818.34

NPVB = 3,500 8,000 13,000

1
+ 2
+ – 15,000
(1 + 0.12) (1 + 0.12) (1 + 0.12)3
= 3,125 + 6,377.55 + 9,253.14 – 15,000
= 3,755.69

NPVC = 42,000 –4,000

+ – 15,000
(1 + 0.12)1 (1 + 0.12)2
= 37,500 + (–3,188.76) – 15,000
= 19,311.22
QUESTION 3

Internal Rate of Return (IRR) is an alternative to NPV used in capital budgeting to measure
the profitability of a project. IRR is a discount rate that makes the NPV of all cash flows
involved in a particular project equal to zero. Generally, a higher IRR is more desirable to
undertake the project.

The first problem with IRR is that it can only be used to decide whether a single project is
worth investing in but not to rate mutually exclusive projects. Besides that, in the case of
alternate positive and negative cash flows, the IRR may have multiple values.

Project A

11,000 7,000 4,800

NPV28% = 1
+ 2
+ – 15,000
(1 + 0.28) (1 + 0.28) (1 + 0.28)3
= 8,593.75 + 4,272.46 + 2,288.82 – 15,000
= 155.03

11,000 7,000 4,800

NPV29% = 1
+ 2
+ – 15,000
(1 + 0.29) (1 + 0.29) (1 + 0.29)3
= 8,527.13 + 4,206.48 + 2,236 – 15,000
= –30.39

IRR = 155.03
28 + (29 – 28)
155.03 – (–30.39)
= 28 + 0.836
= 28.84%
Project B

3,500 8,000 13,000

NPV23% = 1
+ 2
+ – 15,000
(1 + 0.23) (1 + 0.23) (1 + 0.23)3
= 2,845.53 + 5,287.86 + 6,985.99 – 15,000
= 119.38

3,500 8,000 13,000

NPV24% = + + – 15,000
(1 + 0.24)1 (1 + 0.24)2 (1 + 0.24)3
= 2,822.58 + 5,202.91 + 6,818.33 – 15,000
= –156.17

IRR = 119.38
23 + (24 – 23)
119.38 – (–156.17)
= 24 + 0.433
= 24.43%

Project C

42,000 –4,000
NPV170% = 1
+ – 15,000
(1 + 1.70) (1 + 1.70)2
= 15,555.56 + (–548.70) – 15,000
= 6.86

42,000 7,000
NPV171% = 1
+ – 15,000
(1 + 1.71) (1 + 1.71)2
= 15,498.15 + (–544.65) – 15,000
= –46.50

IRR = 6.86
170 + (171 – 170)
6.86 – (–46.50)
= 170 + 0.129
= 170.13%
QUESTION 4

Modified Internal Rate of Return (MIRR) is the discount rate that makes present value of
cash outflows equal to the future value of cash inflows.

The advantages of MIRR include:

i. MIRR assumes that all cash flows are reinvested at the required rate of return

ii. MIRR is closely related to NPV, leading to the same decision compared to IRR

iii. By using MIRR, it is no longer possible to get multiple answers

Despite the advantages mentioned above, MIRR still has its disadvantage. MIRR can still
lead to incorrect decisions when mutually exclusive projects are involved.

Project A

Total FV = 11,000 (1 + 0.12)2 + 7,000 (1 + 0.12)1 + 4,800

= 13,798.40 + 7,840 + 4,800
= 26,438.40

15,000 (1 + r*)3 = 26,438.40

r* = 20.79%

Project B

Total FV = 3,500 (1 + 0.12)2 + 8,000 (1 + 0.12)1 + 13,000

= 4,390.40 + 8,960 + 13,000
= 26,350.40

15,000 (1 + r*)3 = 26,350.40

r* = 20.66%

Project C

Total FV = 42,000 (1 + 0.12)2 + –4,000 (1 + 0.12)1

= 52,684.80 + (–4,480)
= 48,204.80

15,000 (1 + r*)3 = 48,204.80

r* = 47.57%
REFERENCES

http://www.investopedia.com/terms/p/paybackperiod.asp

http://www.investopedia.com/terms/d/discounted-payback-period.asp

http://www.investopedia.com/terms/n/npv.asp

https://www.coursehero.com/file/p1ufg0u8/Properties-of-NPV-i-The-net-present-value-is-
usually-high-when-income-amounts/

http://www.investopedia.com/terms/i/irr.asp

https://www.boundless.com/finance/textbooks/boundless-finance-textbook/capital-budgeting-
11/internal-rate-of-return-93/disadvantages-of-the-irr-method-404-874/

http://www.investopedia.com/terms/m/mirr.asp

http://harbert.auburn.edu/~yostkev/teaching/finc3630/notes/DecisionCriteria.pdf
 FINANCIAL MANAGEMENT
KPA1233

MINI CASE

TECHNIQUES OF CAPITAL BUDGETING

NAME : SITI AFIQAH BINTI KAMARUZAMAN

STUDENT ID : KBB16012

SUBMISSION DATE : 10TH OCTOBER 2016

SUBMITTED TO : DR. SENTHIL KUMAR